Many of us in India are irritated when the country's state agencies lose cases, and large penalties have to be paid on account of Bilateral Investment Treaties (BITs). But from India's viewpoint, it is efficient to enter into BITs. As India is at an early stage of development, foreign investors face a certain risk of expropriation, and BITs give them protection when such situations arise. We should view penalties paid on account of BITs as the occasional insurance-like payments that help energise large-scale foreign investment into India. It would be useful for the Indian state to harness lost BIT cases as a feedback loop for improving policy framework.

The term of art in this field is "expropriation". When the state grabs private property, this constitutes expropriation. In an early-stage democracy like India, the checks and balances that control the behaviour of the state are limited. As an example, property is not a fundamental right in the Constitution ever since its very first amendment. From the viewpoint of a foreign investor, making business plans in India involves expropriation risk. Alternatively, an Indian state organisation can change a policy in ways that inflict large losses upon private persons.

In advanced economies, the protection of private property and the rule of law create conditions in which private persons are safe. But in India, it's a long journey ahead to graduate into a mature market economy located in a liberal democracy. There is no rapid solution to this problem, other than the long process of achieving mature state institutions.

This is a bigger problem for foreign investors than it is for domestic persons. Locals have a greater voice in the political system and have a better sense of how policies will evolve in future. Foreign investors know less about India, have a low voice in the political system, and may even face a certain degree of xenophobia. For an analogy, consider the ratio of income tax paid by a company to its profit before tax. The rate of tax payment by foreign companies operating in India is systematically higher than local companies. This is because local companies are more confident in their activities, and take greater risks in the interpretation of law. Foreign companies are more unsure, and opt for extremely conservative interpretations.

Expropriation risk and policy risk is difficult to quantify and impacts upon different situations in a non-uniform fashion. It is not easy to label a precise outcome as having involved expropriation. Hence, it is not an insurable risk: It is not a risk against which the global insurance market will supply protection to foreign investors.

In the field of public policy, if we do nothing about this, the required rate of return for investment into India is enhanced to the extent that such risks are present. The hurdle rate goes up, and many investments do not take place.

BITs are an elegant mechanism through which this risk is neutralised. BITs effectively constitute an insurance policy, supplied to all foreign investors, by the Indian government, against expropriation risk and policy risk. In any one case, there can be a legitimate dispute about whether expropriation took place. This calls for a hearing, at a neutral forum, where both sides argue their case. As an example, arbitration in London is a good way to get high-quality rulings.

The very presence of a BIT creates an additional layer of checks and balances against bad behaviour by Indian state organisations. Even when BIT litigation and damages do not come about, they are at work, invisibly improving the quality of policy work.

For a foreign investor, a strong BIT creates peace of mind. A certain class of risks are removed from consideration. This encourages greater investment into India, which is in the country's interests. In the annual investment flow of about $500 billion into India, there will always be a few episodes where a state organisation has behaved badly, and there will be a steady flow of payments of a few billion dollars a year, on account of these cases. This is a good deal, from India's point of view. We should view these small annual payments as being like insurance payments that undergird the vast enterprise of foreign inflows each year.

When an individual employee in a government department is challenged with a BIT, she has to do the work of dealing with an arbitration in London. She faces the potential consequences of losing, and then of having to find resources in the public finance system to pay damages. This work is irksome for the employee. However, we should see that the flow of a few lost cases a year is the price that we pay for reducing the hurdle rate for the vast capital flows into India. There is a gap between the perspective of the people of India and that of the official that contests a case.

Entering into strong BITs can kick off a spiral of policy reforms through which expropriation risk comes down, the rule of law is strengthened and policy risk is reduced, as follows. The political leadership should view each lost case as a bug report, as a trigger for commensurate policy reform. Each lost case should lead to improvements of the policy framework through which similar situations would not recur. Over the years, as the policy frameworks improve, the flow of payments per year would dwindle away, thus signalling that India has become an advanced economy. At this point, BITs would become relatively unimportant, they would become insurance contracts against extreme events that practically never arise.

By this reasoning, countries come in four kinds: (A) Advanced economies that do not need BITs, (B) Emerging economies which harness BITs well, (C) Developing countries that harness BITs to limit state power and protect foreign investors but lack the feedback loops, and (D) Developing countries which lack BITs.

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